Unique business model of the financial services industry and future challenges arising therefrom

Text of the Speech at AFinFo 2019 – Accounting and Finance Industry Forum at the University of Ruhuna (July 25, 2019)

Needless to say, we are living in quite turbulent times. This turbulence is caused by factors such as technological breakthroughs, demographic changes, regulatory developments, sustainability concerns, new business models, socio political unrest and so on. Corporates cannot and should not take their survival for granted any longer. Financial institutions are no exception.

Let me start with a quotation from a PwC report on “Retail Banking 2020 – Evolution or Revolution?”

“Powerful forces are transforming the retail banking industry. Growth remains elusive, costs are proving hard to contain and ROEs remain stubbornly low. Regulation is impacting business models and economics. Technology is rapidly morphing from an expensive challenge into a potent enabler of both customer experience and effective operations. Non-traditional players are challenging the established order, leading with customer-centric innovation. New service providers are emerging. Customers are demanding ever higher levels of service and value. Trust is at an all-time low.”

This statement precisely describes the status quo of the entire financial services industry anywhere in the world today. This suggests that the evolutionary approach of “doing it a little better” is not going to help anymore, but it requires a revolutionary approach like those of Tesla, Apple or Google – of conceptualising cars as “computers on wheels” or, as Michael Corbat (CEO Citibank) remarks, of describing Citibank as “a technology company with a banking license”.

Industries like communications, IT, transportation and healthcare have witnessed “out of the box” innovations in the recent past that have dramatically changed stakeholder experience. Think of the impact caused by MRI and IBM Watson to medical diagnostics, Facebook to social networking, Spotify to music, Netflix to movies and so on. I believe that the financial institutions (FIs) sector is yet to offer a similar breakthrough; hints and traces are already there that it can happen sooner than later and by anybody anywhere in the world. Whoever “invents” that model will be the winner!

The fourth industrial revolution, driven largely by the convergence of digital, biological, and physical spheres, will fundamentally alter the way we live, work, learn, commute, play, pay, be present and relate to one another. Again, banking is not going to be an exception. In terms of scale, scope, and complexity, the transformation will be unlike anything humankind has experienced earlier.

Given these circumstances, the contents of my speech is structured under four broader headings. They are:

1.   What makes the business model of FIs unique

2.   Challenges arising from the conventional business model

3.   Common challenges affecting the industry

4.   Way forward

Let me explain.

1.   What makes the business model of FIs unique

Banks have a rigid and conservative business model. It revolves around two primary activities, namely financial intermediation and maturity transformation.

Financial intermediation refers to the intermediary role the banks play between various stakeholders – depositors and borrowers, importers and exporters, money remitters and beneficiaries, entrepreneurs and investors, tax authorities and tax payers and so on. Maturity transformation refers to the process of converting short-term funds into long term lending and investments.

Financial intermediation and maturity transformation cause the business model of FIs to substantially differ from other business organisations. As you can see in the table below, the principal difference is the substantially lower Return on Assets (ROA), which is less than 2% in general, in stark contrast to around 10% earned by corporates in other sectors. This prompts FIs to resort to the process of gearing in order to make the returns to the investors attractive in terms of Return on Equity (ROE). Gearing involves expanding the business volumes by mobilising more and more funding from depositors and other providers of funds and lending or investing such funds in earning assets on the strength of a given amount of capital. This is a funds based operation that generates net interest income which accounts for over 75% on average of the total operating income of an FI today. 

Low ROA, high gearing and acceptable ROE

* Since 2018/19 Financial Statements had the impact of IFRS 9 first time implementation.

Accordingly, gearing remains the foundation of the business model and enables FIs to operate at around 10 times higher business volumes compared to the shareholders’ equity. It is their license to mobilise deposits from the public that has made it possible. However, gearing exposes the FIs to a multitude of internal and external risks. In addition, certain emerging global developments are now threatening to disrupt this conventional business model, as I will explain later during my speech.

I believe that all intermediary roles will increasingly come under pressure with the emerging developments. However much oversimplified it may appear to be, I would like to draw an analogy between an FI and a trader in the Dambulla Economic Centre. The latter does not grow any vegetables, but merely acts as an intermediary between farmers who bring their produce to him and the wholesale buyers who come to him to buy the produce. The day is not far away when the farmers and wholesale buyers can do their transactions in a virtual market. An FI is no different. The day the depositors and borrowers can meet in a virtual space, FIs will no longer be necessary!

Another interesting observation with regard to the FIs is their relatively lower Price to Book Value (PBV) across the world. While the PBVs of almost all the other industries have been improving, it is noteworthy that the PBV of FIs has been on the decline over the past several decades. Unlike the book value which is historical and based on accounting standards, price or market value reflects perception of the future earnings power of corporates as going concerns. Given below is a comparison of PBVs of a few FIs with corporates from other industries.

PBV of FIs versus other corporates

2.   Challenges arising from the conventional business model

Built on a costly conventional business model that revolves around a few products delivered through an extensive brick and mortar network which is not sustainable in the long run, banks are increasingly facing formidable challenges as a result of the emerging developments referred to above.

On top of the list are the growing regulatory developments. Ever increasing capital requirements are making banking a capital-intensive business and less attractive for the investors due to lower profitability. Some regulations such as restrictions on online KYC are inhibiting banks from augmenting customer experience. Increasing regulatory requirements and enforcement actions and fines have substantially increased costs of compliance.

Moves towards “open banking” through APIs in the EU/EEA (as directed by PSD2) and the setting up of “Special Purpose National Banks” in the US too are forcing banks to innovate. Big data and robotics are opening new vistas for bankers.

Deterioration in asset quality and the implementation of IFRS 9 are affecting the bottom line of banks that are heavily relying on fund-based operations (which accounts for upto 80% of income). Causing a double whammy, banking products are being unbundled by fintechs and techfins, causing banks to lose a part of their fee-based income. 

Governments of some of the countries are using FIs as a captive source for tax revenue with effective tax rates being as high as 50%. Legacy systems are preventing analysis of data for information and insights. Potential for systemic risks from cyber attacks and demand for ransom payments are on the rise.

Overall, with declining profitability and PBV, the attractiveness of the sector to investors is fast fading away globally. It is an irony that investors are shying away from FIs at a time when FIs need them most. However, as going concerns, companies are valued for their earnings power and not for their book value. So, quite apart from meeting customer expectations, FIs need to look for that delivery model that will make them profitable.

3.   Common challenges affecting the industry

In addition to the challenges arising from their conventional business model, FIs face certain challenges in common with many other industries.

Today, the context (operating environment) and the perspective (outlook) are not as clear as they were. In the past, corporates knew where the competition was likely to come from, there were barriers to entry, patterns of demand were known, who the stakeholders were was precisely known and there was much less concern for sustainability.

Due to the impact of certain emerging mega trends – such as globalisation, digitalisation, exponential technologies like quantum computing, AI, robotics, blockchain and crypto currencies, unorthodox competition, demographic changes, augmented analytics, the move to a circular economy – the most longstanding and widely held assumptions we had about markets, competition and even business fundamentals are less valid today.

Millennials are demanding the same level of service and innovation that they get from Amazon, Apple, Facebook, Google and Uber or their Asian equivalents of Alibaba, Baidu, Didi, Tencent, or Xiaomi. Customers, millennials in particular, tend to value convenience, experience and simplicity above everything else.

There are growing concerns for sustainability, calling for equal emphasis on social and environmental aspects, besides economic performance. With immediate causes for many corporate failures being anything but lack of resources and the absence of corporate will to continue operations for the foreseeable future, the conventional accounting concept of “going concern” is more of a “growing concern” and appears to be less valid today. There are growing numbers of corporate failures which were going concerns in accounting terms, yet failing due to factors beyond resources and corporate will.

 Some of the developments referred to above are challenging conventional business models with profound impact on their sustainability. As a result, it is no longer business as usual, thereby making the historical financial performance of a corporate less relevant for any assurance about its future potential. Future potential has to be evaluated on its own merits. This is because historical performance deals with only the financial value created which is the net outcome of value delivered to the various stakeholders and value derived from them. But, the emerging developments have made the entire story of delivering value to and deriving value from stakeholders important today. Therefore, corporates need to communicate their whole story of creating value for all their stakeholders in the short, medium and long term. With the communicating power shifting to individuals and grassroots, anybody can be a stakeholder today.

Non-financial or off-balance sheet information is gaining more importance for determining value and future potential of corporates. Rosy pictures depicted through annual reports are not going to be much help, because they are primarily harping on the past.

Back in 1994, Bill Gates remarked that “Banking is necessary; banks are not”. It was a kind of a prediction then. 25 years later, it has become a reality. The changes that we witness today set the context for the need for financial services and how such services will be availed.

4.   Way forward

In the circumstances, the need for FIs to innovate and transform themselves to be fit and agile for the times need not be over emphasised. In fact, FIs have all the ingredients needed to reinvent themselves – technology, customer data, and reach. All what they need to do is to hustle and find that all illusive business model and strategies which will help them survive sustainably.

In this regard;

  • FIs need to accept the fact that evolution is real and disruption will be the norm. Disruptions to the conventional FIs in fact gained momentum with diminishing trust – post financial crisis, growing customer expectations, the rising influence of millennials, growing mobile-, internet- and customer-friendly regulations. Millions of customers have already turned to non-bank technology companies for their financial services needs
  • FIs need to see themselves as technology companies with banking licenses, as Michael Corbat, CEO Citibank aptly remarked in 2017
  • FIs need to collaborate and co-create since emerging developments offer opportunity as much as they cause disruption
  • FIs need to avoid conduct risk, which is the unethical behaviour that was attributed as the primary cause of the 2007 financial crisis. 
  • FIs need to live by the claims they make since unsubstantiated claims and failure to live by those claims made are very likely to jeopardise their sustainability and credibility today
  • FIs need to simplify their product offering based on an excellent understanding of the customer
  • FIs need to generate insights about the customer behaviour from the vast amounts of data with them to innovate and personalise the value proposition, ideally targeting a “segment of one”
  • FIs need to continue to innovate since it is said that “the emerging developments are so powerful that the only remaining sustainable advantage lies in consistent innovation”
  • FIs need to accept the fact that society is looking for alternative banking models, as clearly evident from the continued growth of the “informal” sector for financing and make the offering more and more inclusive, targeting the underbanked and the unbanked
  • FIs need to lobby for regulatory support through changes in legislation needed to remove pain points in the customer journey and offer that degree of simplicity, convenience and experience customers value most

In conclusion, what will that winning model be –

  • a hybrid system combining conventional banks and fintechs?
  • a freemium model?
  • a platform based system (as fulfilled by Amazon)?
  • a crypto currency based system? Or
  • ………………?

Only time will tell.

Anybody can be the catalyst of that change.

So, let your imagination run riot!

Raja Senanayake
A Chartered Accountant and the Chief Officer Smart Academy at Smart Media The Annual Report Company

© Copyright February 2020
The ideas discussed here may be used, adapted or built upon for academic or commercial purposes provided due credit is given to Smart Media The Annual Report Company as the originator of this work.